Reddit is mostly irrelevant again, and many of the meme stocks have crashed back to earth (though not GameStop). But just as with GameStop, there’s a fundamental truth that stocks and other financial assets are just tokens whose price is determined by supply and demand. Most of the time it is demand that matters most, with large amounts of supply—IPOs and secondary issues—usually a symptom of excessively high prices.
It turns out that one of the biggest drivers of that demand in the long run is how unequal society is.
The argument is pretty simple, as laid out by Jacques Cesar, a former managing partner at Oliver Wyman now leading a research project for the management consultancy: The rich save more and are more willing to take the extra risk of putting their savings into stocks. Mr. Cesar calculates that one household earning $1 million a year would put about 20 times as much into stocks as the total invested by 20 households each with an income of $50,000, based on averages for their income groups, even though their overall income is the same. Raise inequality and demand for stocks goes up, and so do prices.
This doesn’t mean traditional financial metrics are irrelevant. But it helps explain why there has been an upward trend in valuations over the past 40 years, as U.S. inequality has soared. More millionaires and billionaires are buying stocks because there are more millionaires and billionaires. At the same time, there are more millionaires and billionaires because profit margins are high—for many reasons, including increased monopoly power—and companies choose to pay their top people much more than in the past.
“There’s a duality," Mr. Cesar says. “Ultimately they’re two faces of the same coin. [Company] earnings are both cause and consequence of high income inequality."
Oliver Wyman has constructed a model of demand for stocks that tries to assess the effect of inequality and two other long-running shifts. These are the rise in willingness of pension-fund managers to hold stocks since the 1950s and the easier access to stocks for ordinary investors, both through lower fees and the popularity of funds.
This “demand-weighted income" measure is then compared with household equity wealth to come up with something akin to a slow-moving price-to-earnings ratio. It had a closer link to future returns than Yale Prof. Robert Shiller’s cyclically adjusted price/earnings ratio (CAPE) since 1900. In large part that’s thanks to the failure of CAPE to fall back down to historical norms in the past 20 years, as both margins and U.S. inequality have risen.
A price-to-inequality ratio won’t replace a simple price-to-earnings gauge. Inequality data are slow to be produced, so this can’t be used as a real-time indicator. Inequality has gone through long trends over the past century, falling from the Roaring 20s high of 1929 until Ronald Reagan’s election in 1980, then rising again, so there aren’t lots of big turning points to judge the past by. And Mr. Cesar’s model is based on past data, so may not work in future.
Still, the logic of inequality driving more demand for stocks is compelling—even if it assumes that the supply side, corporate issuance, continues to be held back by management incentives and corporate governance.
The most traditional of traditional finance might push back against all this, and say that there is a correct valuation for a stock, we just have to figure out what it is. I disagree, and think there’s no Platonic ideal of the PE ratio out there to discover. Exactly how we convert the future flow of profits into today’s price depends both on bond yields and on the risk appetite of investors. There are times valuations and risk appetites are obviously out of whack with reality—as with the dot-com bubble, meme stocks or the simultaneous bubblein clean tech shares—but the range of reasonableness is large, and the “right" level is a function of supply and demand.
In the short run, supply and demand depend on the balance of fear and greed. In the long run, the more inequality, the better for stocks (and other financial assets). And since we can look for turning points in inequality, maybe we can use it to make forecasts.
“Once you understand that inequality and margins are the same thing, to think about the future you can think about either the traditional or nontraditional view," Mr. Cesar says. “And it’s easier when you think about the long term to think about inequality and politics."
At the moment it’s possible to imagine we are at a turning point in inequality. Major 40-year trends such as globalization and the shift away from U.S. manufacturing appear to be reversing, driven by national-security and supply-chain-reliability concerns, the need to invest in clean energy and the U.S. position as an energy powerhouse. None of that would be good for profit margins, while postpandemic demand for workers has led to much higher pay rises for low-skilled workers than the university graduates who were the winners of the past 25 years.
At the same time, there’s little prospect of a Franklin Roosevelt-style shift to redistribution, worker power and industrial policy with a political system now balanced close to 50-50 at every election and fiercely partisan.
Mr. Cesar reckons a major shift toward more equality is highly unlikely at the 2024 election, which should allow valuations to maintain the higher levels that set in after Reagan. Readers will have their own views on who’s likely to be the next president, although even if one calls it right, recent history suggests it is hard to know what his or her policies will be once in the White House.
I suspect that even without major domestic political changes, the end of many of the big trends of the past 40 years could also keep inflationary pressure and interest rates higher, stock valuations lower and the jobs market hotter, pulling toward a little less inequality. That ought to mean lower underlying demand for stocks—unless another GameStop-style surprise brings in a new group of buyers.
